June 27, 2011

Stimulating small business activity: Still a struggle

In testimony before Congress on June 22, U.S. Treasury Secretary Timothy Geithner laid out the disproportionate effect the financial crisis has had on small businesses and particularly their ability to raise funds:

"The banking and credit component of the economic crisis was especially damaging for small businesses, which are more dependent on bank loans for financing than are larger firms. Alternative forms of financing, through household credit via mortgages and credit cards, were also deeply compromised by the financial crisis. Mortgages and other loans account for four times the share of liabilities for non-corporate businesses as they do for corporate businesses. Total lending to non-financial businesses shrank for nine straight quarters starting in the fourth quarter of 2008, before turning slightly positive in the first quarter of 2011; on net, lending has declined by a cumulative $4.2 trillion since Fall 2008. Over the same period, larger businesses were able to raise $3.6 trillion by issuing debt securities."

Evidence from the Atlanta Fed's latest small business finance poll of approximately 182 firms in the Southeast confirms that many firms are still struggling with financing. Total financing received among repeat poll participants edged up only slightly in the first quarter of 2011 from the previous quarter. Further, 43 percent of participants overall reported that tighter lending practices are hindering access to credit. In addition, when offers of credit do occur, they often do not materialize into loans as a result of the unfavorable credit terms being offered. In fact, 41 percent of applications to community and regional banks and 57 percent of applications to large national banks were refused by the borrower, according to the first quarter poll.

In response to these ongoing problems, the Administration has created several programs to help small business obtain funding. One is the Small Business Lending Fund (SBLF). Created by the Small Business Jobs Act in September 2010, the fund began accepting applications in December 2010. The SBLF was set up to provide an incentive for financial institutions with less than $10 billion in assets (mostly community banks) to boost lending to small businesses.

Under the terms of the program, the more small business lending increases, the greater the benefit to the institution. In theory, shoring up the balance sheets of the banks in exchange for an increase in small business lending would result in an increase the amount of loanable capital. Further, there would be a greater opportunity cost for failing to bring loans to closure, and this cost could result in borrowers receiving more appealing credit terms. As a result, those small businesses currently rejecting loans based on the cost of funds could see credit terms ease, resulting in more acceptances and an expansion of small business loans. (You can read more about the details of the SBLF here.)

Unfortunately, the program, which closed out June 22, was not very popular. As of the morning of June 22, the Treasury had received 869 applications out of 7,700 eligible lenders. All together, they requested only $11.6 billion out of a possible $30 billion from the program.

Why was participation so low? One potential reason is lack of demand. According to Paul Merski, chief economist and executive vice president of the Independent Community Bankers of America, "You're not going to pull down capital unless you have loan demand."

If demand for small business loans is not expected to pick up, then what is restraining demand?

One possibility that we considered in a macroblog about a year ago is that demand is being restrained as a result of the perception of tight credit supply. Creditworthy borrowers could be assuming they will be denied so they are not applying. Another possibility is that demand is constrained because of economic weakness. To get a handle on the extent to which these factors are restraining demand, we turn back to our small business finance poll. In the poll, we ask those who did not seek credit in the previous three months why they didn't seek it. The chart below shows the responses to the question. (Note that survey participants can check more than one option.)

At first glimpse none of the reasons seem to dominate. However, if we categorize the responses into "I didn't need credit" and "I didn't think I'd able to get credit," the graph becomes a little more useful.

The graph below shows the responses placed into these two categories (where possible). Firms that only marked "sales/revenue did not warrant it," "sufficient cash on hand," or "existing financing meets needs" are put into the "I didn't need credit" category. Meanwhile, firms that only said "unfavorable credit terms" or "did not think lenders would approve" fall under "I didn't think I'd be able to get credit."

We do not claim that our survey is a statistically representative sample, and we of course can only reach existing businesses. The survey is silent on potential new businesses that were not formed because of credit issues that the SBLF could potentially address. With those caveats, we do find that the majority of firms (66 percent) did not borrow because they didn't need to or want to. Whatever the merits of the SBLF program, it appears that understanding why those businesses that are fully capable of expanding are not doing so is at least as important as understanding the slow pace of SBLF activity.

Comments

Banks and businesses large and small are stuffed to the gills with cash. Two things that could induce them to spend it are: rising inflation and rising interest rates. Two things the central bank fights hardest to do: hold down inflation and flatten rates to zero as far into the future as possible.

It is the community banks in this country that better serve small businesses. They are important customers at our small banks.
The SBLF will probably only disburse about $2 to $3 billion of those funds because of dividend restrictions imposed on many community banks by the federal reserve as a result of the economic crisis.
SBLF could make a difference because it hits home. Rigth were small businesses need it, at their local community bank.
If you have a business with revenues less than $1mm per year you are not an important customer at the larger banks and they will not assist during this recession.

Rising inflation can only induce someone to spend money IF they were predetermined to "want" the item, or investment, prior to the bout of inflation. If I "wanted" to buy a new car that costs $20,000 but did not "need" the new car, please explain why the car suddenly costing $25,000 would prompt me to rush out and spend my capital on it? I would assert that it wouldn't. Rising inflation on investment opportunities in fact makes the investment opportunity less compelling not more.

The same holds true for rising interest rates. Rising interest rates only prompts would be borrowers to rush out and secure debt financing if they "wanted" it before the interest rate increases. If they didn't "need" debt financing before, they sure don't perceive themselves as needing debt financing when it is more expensive.

Business small and large have become increasingly risk averse. Debt financing for ANYTHING makes a business riskier not less. I would also assert that debt financing for existing operations adds very little (if any) value to the business. Debt financing for new capital projects CAN add value to the business BUT it also increases risk to the business. Thus, in a world of more risk aversion there is naturally less demand for loans a.k.a. leverage.

The underlying secret that is spreading among businesses is that the "just add leverage" American way is not a sound business strategy. Many businesses of all sizes have caught on to this fact. They seem to only be considering taking out debt financing if they "need" it.

In my opinion a tremendous factor in the increase in risk aversion is the outrageous cost of failure that has only been increasing over the past 30 years. Ironically this is largely because of inflation. Most start-up businesses cannot afford healthcare for their owners or employees. Start-ups initially struggle to provide enough cash (let alone income) to provide for food, transportation, technology, etc. This is only worse when the entreprenuer has a family...as he or she is obligated to provide for other people. So, not only will the start-up struggle to provide for their family...in the event it goes under they will be facing tremendous losses, increased costs through bankruptcy issues, AND they will STILL be obligated to provide for their family (with less resources).

Even a less extreme case...lets just say I wanted to go back to graduate school to secure a better job in a different field or start my own business after school. I will have to take out a student loan that cannot be dissolved EVER and is typically required to be paid back in 10 years (as I understand it). That is potentially over $100,000 in debt that, in the event things don't pan out well, will be a plague for the rest of my life. Repeat the same process of not being able to provide the basic necessities of life such as food, clothing, healthcare, shelter, etc. to my own family and hopefully you will get my point.

You want to increase small business activity? Stop trying to engineer inflation...and reduce the cost of failure to those with a good idea and the drive contribute to society by creating their own business! At least that is my idea for the moment.

We are finding that it difficult to force businesses to borrow money. The main reason a small business wants to borrow is if they see demand expanding for their goods or services. If small business owners don't see demand rising for their products, they will NOT want to take on MORE risk by borrowing. Low interest rates, gov't programs, tax credits, lower taxes, and a plethora of other programs will NOT make a difference. It will not encourage small businesses to borrow.

The problem may be very complex, but the widening income gap in the U.S. has to be part of this issue. If the average consumer has a smaller share of the economy, then it stands to reason that their consumption percentage of the economy will be lower.

The trickle down theory that Republicans seem to be wedded to, will only result in the U.S. economy trickle down the list of vibrant economies.

The great economic expansion that we have enjoyed from the 50s through the 90s was directly attributed to the rise of the middle class and their increasing share of the U.S. economy. If politicians want to reinvigorate the economy, perhaps they should consider how our national income and taxes are distributed throughout our society.

It is not that I disagree with the idea that "demand" comes before investment or at the very least concurrently, but in fact it is the disingenuous efforts of politicians to use the notion that demand comes first to waste hundreds of billions of dollars on unproductive crap that is in reality designed to do little more than help them win election. At the core, state capitalism works the same way the private enterprise system works if either are to succeed: over the long run both have to make investments that are at best profitable or at worst economically feasible. In the U.S. we happen to be cursed with politicians who do not have the personal responsibility or accountability or historical track record (in the past 20 years) of making such decisions. Thus, many people find the notion of the free market system far superior to that of state run enterprise.

On the wealth gap. I have started to ponder a new notion of the origin of the existence of a wealth gap which has been expanding in the past 20 years. Presently I believe that the disparity between the middle class and the upper class stems from poorly constructed rules, regulations, and incentives. In a world in which the government can craft "perfect" rules/regulation the chances of wealth creation are reasonably fair between the economic classes. Yes there are probably disparities that still exist, but from 1950-1990 there are countless examples of rags to riches or probably even more plentiful rags to a great middle income lifestyle. In the world with perfect regulation income becomes more of a function of true work ethic.

However, in a world of less than perfect regulation...there is an arbitrage that takes place between the better mentally equipped, and financially backed people, and the middle income or poorer classes of people. Quite simply the vast majority of the brain power (which is a minority of people) invests the majority of time determining how they can make the most money in a relatively easy fashion. Why do you think there are SO many terrible lawyers in the world?

Having imperfect rules to the game isn't the only ingredient to an expanding wealth gap. A general decline in morality has to occur as well. It is not enough to have the opportunity to screw other people for money but rather you have to have the desire to do it as well. It doesn't have to be necessarily malicious. It can simply be as easy as a doctor who charges different rates depending on what insurance provider you use. While I am sure there are rules against such a thing, try to keep a straight face and say it doesn't happen on a WIDE scale. Bet you can't do it.

What we need in my estimation is to stop trying to craft the perfect regulation. Begin re-incorporating ethics/morality/human interests into the classroom and probably most importantly the business, legal, medical and any other professional classroom. Sure there have been significant increases in ethics topics in classrooms but I would assert those too are primarily focused on the letter of the law and not the spirit of it...which I would argue is "don't try to screw other people for a living".

Imagine a world where businesses, individuals, and politicians made decisions for their own self interests BUT made a conscience effort to align their self interests with that of society as a whole?

Don't make it so easy on the rich to keep getting richer. They are smarter than you or I. Make it easier for the middle income or poor people with a good idea to experience manufacturing and monetizing that good idea. Just some additional pennies of my thoughts.

After the huge recession a number of small business including large business ventures are lost its shines due to lack of funding and outputs, as small business are totally depend upon bank loans for their funding therefore they are severely effects during the period of recession.

So in response to save the small business banks are really played an essential role in the developing process.

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